285: Chinese Evergrande and the state of the Global Economy!
Catch the full episode: https://www.wealthformula.com/podcast/285-chinese-evergrande-and-the-state-of-the-global-economy/
Buck: Welcome back to the show, everyone today my guest on Wealth Formula podcast, well, he is very familiar to you by now. He’s the guy who kind of keeps this up to date on the world economy. His name is Richard Duncan. He is the editor of a fantastic newsletter video newsletter called Macrowatch, which we’ll get into in a little bit. But Richard, welcome back to the show.
Richard: Thanks, Buck. It’s great to speak with you again.
Buck: Yeah, it’s funny. Every time we get you back on, it ends up being just a few months. But then it seems like we’re the world is moving. It’s a ridiculous volatile pace, and it’s completely different things to talk about.
Richard: Well, that’s right. I think the last time was about seven months ago. Could be wrong. But that’s what I saw in my calendar.
Buck: Yeah. And that would be in a few decades ago. That would have been probably the equivalent of three or four years later, but not these days. So I’ve been watching you and have been listening to you lately, and I know one of the things that you’ve been talking about is this liquid tsunami. Tell us about what exactly is the liquid tsunami?
Richard: Okay, well, so it was just about seven months ago when I published a Macro Watch video called Liquidity Tsunami that may drive asset prices much higher. So what that was all about was, of course, the Fed at that time was creating $120,000,000,000 a month as it still is. And it was expected to continue doing that well into the future. So that alone would be an enormous amount of money going into the economy every month, multiply that by twelve months. And that’s $1.44 trillion new money going into the economy per year if it had lasted for a full year. And then on top of that, the Treasury Department had built up this huge stockpile of cash in his bank account at the Fed, which is called the Treasury General Account. The money was just their park. They’re not doing anything. But they were projecting that they were going to run that cash down by spending it. And as they spent that money, something like approaching a trillion at the peak they had $1.8 trillion in that account that was in the middle of last year, and they were projecting they were going to run that down. So this combination of the treasury spending all its cash word injecting money into the economy and the Fed injecting $120,000,000,000 a month into the economy looked like it was just going to flood the financial markets with liquidity with the potential of driving asset prices much higher. And so since then, that’s pretty much what we’ve seen right up until a few days ago. Anyway, between that March video and just a few days ago, the S Amp P 500 was up 16% in that seven month period. Property prices are up. Home prices are up year on year. The only thing that’s really disappointing has been gold. Gold only went up 3% during that seven months. So the financial markets were pretty much on fire. Now, however, things look like they’re about to change. This liquidity tsunami is about to come to an abrupt end, it appears. And that was the name of my last video.
Buck: So tell us, why is that obviously the liquidity tsunami, along with very low interest rates, has definitely played a significant role in driving up asset prices. But tell us a little bit more about what goes into the end of the liquidity tsunami.
Richard: Okay, so a couple of weeks ago at the Fed’s last FOMC meeting, they made it pretty clear that they intend to start tapering quantitative easing either in November or December. And Furthermore, they intend to bring this whole quantitative easing thing to a close by the middle of next year, so that’s a little bit sooner than people had expected than the markets had expected. Generally, the markets had anticipated the Fed to start tapering in January, and the tapering process would go on pretty much all year long and in some time near the end of the year. So what we’re seeing is sooner and more aggressive tapering. So that means that the Fed will end up creating less money than the markets have been expecting. So depending on whether they start in November or December, I’m assuming that they reduced the size of quantitative easing every month by about $15 billion a month. That means they’re going to create something like between 550,000,000,600 and $50 billion between now and the middle of next year that’s less than had been expected. And so that will bring at that point. Then quantitative easing will come to an end, and the Fed will stop increasing, creating money on a significant scale altogether. So the tapering is happening faster and more aggressively than had been expected. And now, on top of that, the Treasury Department has run down its cash hoard. I mentioned that last year at 1.8 trillion. Now it’s below 200 billion. What they’re telling us now is if they intend to increase that to $800 billion by the end of the year and by increasing the cash that they keep at the Fed that will take roughly $600 billion out of the economy. And it will just simply be parted in the Treasury Department’s Bank account at the Fed. So that could end up being if they actually do that, that will take out $600 billion from the financial markets. That will be more than the Fed injected during the next three months. Great. So that’s actually so instead of the markets being flooded with liquidity from the Fed and the treasury, what we’re going to see actually is the beginning of a liquidity drain where liquidity is withdrawn from the financial markets. So that’s going to create an entirely different and much more difficult economic environment. Then when the financial markets have grown accustomed to right, we’ve been inundated with liquidity. Asset prices have been on fire, speculative stocks and have been going to the moon. And now all that’s likely to come to an end. And the problem is okay, there’ll still be a lot of liquidity. But the main force that had been pushing asset prices higher, it was just ongoing month after month surgeon liquidity. That was the main driver of asset prices, and that’s now going to stop. And the problem is asset prices are now so expensive that they’re really vulnerable to a significant correction.
Buck: One question for you on the tapering of Fed’s quantitative easing that results in a side effect of higher interest rates, too, doesn’t it?
Richard: So that would depend on the supply and the demand for new government bonds. And I think one of the main reasons that the third, perhaps the main reason the Fed is going to taper aggressively is that the government is going to be borrowing much less money. And it has in the recent past, for example, in the fiscal year, the government’s fiscal year ends at the end of September. So in fiscal year 2020, the government borrowed the budget deficit was $3.1 trillion. In the fiscal year that just ended a few days ago, the budget deficit was projected to be around $3 trillion again. But for the next fiscal year ending September 3022. In other words, this year that we’re currently on, the budget depth is expected to be only just about 1.1 trillion. So rather than the government having to borrow 3 trillion plus to fund this budget deficit as it has over the last couple of years, this year will only be borrowing 1 trillion. So if the Fed continued with quantitative easing at the rate of $120,000,000,000 a month or $1.44 trillion a year, the Fed would end up creating more money and buying more government bonds when the government actually sold in this upcoming year. In fact, about $300 billion roughly more. So the Fed actually created more money and bought more government bonds than the government sold. That would mean the demand for bonds from the Fed and other sources would be much greater than the supply. So that would push up bond prices. And when bond prices go up, the bond yields go down so that could have resulted in bond yields faulting the ten year government bond yield. Now it’s roughly about 1.5%. That sort of dynamic could have pushed the bond yield back below 1% and driven this extraordinary mania in the financial markets to even greater heights and created greater bubbles than we already have. And the Fed doesn’t want that. So I think that’s the main reason they’ve decided to paper sooner and more aggressively, because if they don’t, the financial market bubbles are just going to run completely out of control and destabilize the economy when they eventually pop.
Buck: Yeah. The thing is, it’s interesting to me to try to understand the trajectory you describe makes sense. But then you look at the behavior of the Fed over the last several years where if there’s any appearance of anything headed south, the economy starts to look a little bit shaky. They seem to reverse their course pretty quickly.
Richard: Yeah, that’s right. If there’s any major sell off in the stock market, they make some sort of statement to reassure the stock market and take action if necessary. So that’s not their problem at the moment. At the moment, of course, the GDP has been growing very rapidly and the asset prices have been inflating very rapidly. Right. So the thing is, the Fed has to move in slow motion. They have to signal what they’re going to do well in advance, so they don’t get frightened anymore, but usually can’t turn their policy too quickly, so they can make statements suggesting that they may turn their policy if necessary. But that usually is enough to encourage the stock market to stop dropping.
Buck: Yeah. Right. And again, I guess it is to be seen is actually how much they’re going to tolerate. And so they may sort of talk a big game, but if things really start heading south, who knows? I love to see it. They just don’t seem like they’re necessarily stuck to a strategy in any sort of way.
Richard: That’s right. They do have the option to change their mind. Right. And again, one more point on this while we’re here. Yes, that prices really are incredibly inflated. There is one indicator that I look at all the time that I call the wealth to income ratio, right. Wealth to income. And what that actually is is that the net worth of all the Americans, all their assets minus all their debt, their net worth. In other words, their wealth is divided by disposable personal income. In other words, income. So it’s wealth divided by income. And the Fed provides this ratio going back to 950. And the average for this ratio has been about 550%. But during the Nasdaq bubble in 2000, it went up to 615%, which was well above the average. And then, of course, that bubble popped and this ratio went back down to its average. But in the property bubble, they went up to 670%, which was the highest it had ever been by far, 670. And then we know what happened. Then that bubble popped and this ratio went back to its average. Well, now on this ratio. And keep in mind, the previous peak was 670. Right now, it’s 790. So it’s completely off the charts. And if history is any guide, these big peaks are followed by very big crashes. So okay, it’s true there’s a lot of liquidity it’s true. Interest rates are very close to zero. But as liquidity starts to tighten up and as any threat of higher interest rates begins to emerge, asset prices are really very exposed and vulnerable and good experience. Another sharp crash.
Buck: So you said something again, if history is a guide, is history a guide anymore? It just seems to me like if you put Fed policies back a number of these other times that you talked about, I just wonder, would they have behaved differently back then, the way they behave now versus back then? I’m just curious.
Richard: So that’s a good point. That’s a good point. I mean, they certainly would try to prevent the stock market from crashing. Right. Right. When the crisis of 2008 hit, that was the property bubble, the previous peak in this show. Right. The credit started contracting, and they responded pretty aggressively with this new policy. Really quite new policy of quantitative easing on a truly extraordinary scale. Right. And that did manage to eventually reflate the bubble, but not quickly enough. When the pandemic started and the economy started crashing, this time they injected even more liquidity and very fast. And so the economy took a very big swoon and then recovered almost immediately. And the stock market had doubled since their lows in February or March 2020. So, yes, they would respond. But it doesn’t mean that we won’t see a big dip before they do.
Buck: So I want to talk a little bit about the inflation that we see now, the government insists is transitory. What do you think about that?
Richard: Okay, well, let’s talk about inflation. I’m in the transitory camp. And here’s the reason why. So after the crisis of 2008, which seems like a long time ago, the Fed responded with quantitative easing, three big rounds of quantitative easing. And no one had seen anything like that. There has never been anything like that. And everyone had been taught that massive amounts of Fiat money creation by the central bank would inevitably lead to very high rates of inflation. And for the first couple of years after he started, it looked like that was going to be true. The inflation rate did start moving higher, and food prices went much higher. And by 2011, you’ll remember, in North Africa, we had what is known as the Arab Spring. Food prices went up a lot. Some food vendors couldn’t feed his family. He set himself on fire. And this sort of sparked off a revolution across North Africa that toppled a number of governments. And so it really looked like that. This horrible consequence that we’d been told to expect would play out, that there would be very high rates of inflation. And that’s what I believe. 320 eleven inflation peaked then I think around year on year. This is probably core CPI, I guess. But it peaked in 2011. And then what happened? The high food prices resulted in the following year, the farmers planted a whole lot of more crops in food prices came back down and globalization continued to exert strong downward pressure on the cost of manufactured goods. And by 2015, we had deflation again. So despite this extraordinary surge in money creation, maybe the Feds total assets increased by five times between 2008 and 2014. That should have set off hyperinflation, if you believe what we were taught in the economic textbooks at University. But it didn’t. So it didn’t happen last time. I don’t see why it is likely to happen this time. And in fact, what we’re seeing is nothing like what you would expect. The third has created. I think something close to 4.24. $.3 trillion is more than doubled the amount of money that it creates since March in 2020. So in a very short period of time, it’s created more than $4 trillion. And on top of that, the government hit the economy with massive fiscal stimulus, three big rounds, the Cares Act in March 2020, $2 trillion, and then $900 billion more in December 2020. And then in March 2021, another $1.9 trillion. So the government bet increased by $5 trillion between February 2020 and the middle of this year. And the Fed created $4 trillion to help finance that debt. So the Fed effectively financed 80% of this increase in the government debt that the government borrowed in order to stimulate the economy. So that is a recipe for disaster if you believe what the economic textbooks tell us to believe, right. But actually, what have we experienced, in fact? So the course CPI, this is course. Year on year is up. But of course, this is an index. So there’s an actual index level. The index is 4% higher than it was twelve months ago. But if you look back two years, it’s up less than 6%. So the two year average is just 2.9%. Inflation has been 2.9% on average for the last two years. That’s hardly hyperinflation. So there’s some sort of base effects that you have to consider. So it’s important to look at the month on month change in inflation numbers. And if you look at the month on month change, in other words, how much prices go up each month for core CPI? So back in March of this year, the prices were going up. So in February, prices went up. In March, they went up 0.3%. Then in April, after the big stimulus package in April, they jumped up 0.9%. In May, they were up 0.7% in June they were up 0.9%. But after June they started falling. In July, prices were only up 0.3%, and in August they were up 0.1% again. So the average monthly increase during this century, from the year 2000 until August 2021, the average monthly increase has been 0.2%. So last month they were actually up less than the average for the century. And so we’re already seeing the inflationary pressures about and of course, there are a lot of issues. We have the semiconductor shortage. We have shipping shortages. We now have energy prices going higher, in part because of the Hurricane. We’ve had some droughts in Brazil that have caused food, some food prices to go higher, or food coffee is sugar things like that. But despite that, what we’re seeing at the core level is that the inflationary pressures have started to abate. One of the main reasons for that is semiconductors. When the pandemic started, the automobile companies expected demand to be very weak for cars. And so they canceled their semiconductor orders. And by the time they realized that all the fiscal stimulus was going to result in a lot of demand for cars, it was too late to reorder the semiconductors, the semiconductor manufacturers that sold them to someone else. And so this is called the backlog of semiconductors. And so there’s no shortage of new cars. And Consequently the price of used cars shot up. So in April, used car prices were up 10% that one month alone. In May, they went up another. In June, they went up another 10%. So during those three months, the increase in use car prices alone accounted for one third of the increase in inflation. And what’s changed? It was over the last couple of months. Last month in August, used car prices went down 1%. And so without that, that was one of the main drivers of this higher level of inflation. Without that, that’s the reason that the inflation where it was much lower but still used car prices are up 32%, compared with one year ago. That’s not going to last when semiconductors are not going to be in shortage forever. And when the supply returns, there’ll be plenty of new cars again. And used car prices will probably fall by 32%. And just as the increase in used car prices drove up inflation during April, May and June. So at some point over the next year, we’re going to see the opposite effect. They’re going to drop by a month, and that’s going to be a drag on inflation. So these domestic bottlenecks are these international global bottlenecks that we’re experiencing and shortages and supply disruptions. They’re not going to last. These supply disruptions are going to be overcome, as they always are. And on the other side of the equation, there’s the extraordinary demand that has been created by the massive fiscal stimulus, the 3D grounds of fiscal stimulus that’s not going to be repeated so there’s not going to be another trillion dollar stimulus package where people open up their mailbox and get $400 checks. Right? That’s not going to happen anymore. That demand has already hit the economy and it is fading out already. So the demand side is going to weaken. The supply side is going to recover and we’re going to be back in more or less the kind of situation we were before the pandemic with global excess capacity of labor and industrial capacity and great deflationary pressures again with the third struggling to hit US inflation target.
Buck: So I want to shift again to something that seems to be, I guess, is a little unclear how it’s going to affect the world economy. But if you want to talk a little bit about if you would maybe just kind of get people cut up on this whole China Evergrand issue. What exactly is China Evergrand? And why is this a significant potential to us in the US?
Richard: So China Evergrand is either the biggest Chinese property company or one of the very largest, and it is effectively bankrupt.
Buck: Do they own property only in China or in the US as well?
Richard: They may have some investments outside of China, but most of all of their assets are in China. You see these videos now going back for years where you see these Chinese ghost towns, where they’re complete cities where no one lives. Well, Evergrand built some of them. And Evergrand has something like $300 billion worth of debt. And they are now in trouble because the Chinese government has decided for some reason that it’s not entirely clear that they’re not going to allow them to continue rolling over their debt, as they always have in the past, the China’s economy has been a bubble for decades. There has been massive excess supply of property and property inflation going back now. I’ve lived in Asia since 1986, most of the time. And one of the big experiences in my career was watching the Asia crisis in 1997, when Thailand’s economy crashed. Malaysia’s economy crashed. South Korea’s economy crashed and I thought China would as well. It was the bubble, just like these other economies were at that point. But it didn’t. The Chinese authorities managed to control their bubble and just keep it growing. And so I’ve expected China’s economy to have a crisis for decades. But in China, when you’re the government, you can call the central banks and you control all the commercial banks and you effectively control all the corporations. Nobody can go bankrupt as long as you continue to instruct the banks to lend them enough new money this year to allow them to pay interest on all the money they borrowed in earlier years.
Buck: Who’s carrying the debt? I mean, these Chinese banks.
Richard: Chinese banks, but there are also a lot of Evergrand bonds that have been sold internationally, denominated in dollars. So there are foreign holders of this debt as well.
Buck: Are those typically countries that are buying up a lot of this stuff? I mean, who’s buying those bonds? I guess I’m trying to figure out what the exposure is it to the rest of the world.
Richard: It would be like all the people around the world who owned asset backed securities when the property bubble of 2008 blew up. They were here, there and everywhere pension funds in Germany.
Buck: To the same degree?
Richard: You never know until the whole thing ends, but probably not to the same degree, but spread out to the same extent. But the amounts involved are probably not as large internationally one.
Buck: So how big of a problem is this for us? Do you think or is this one of those things that we’ll just have to wait at this point, obviously, we will have to wait and see. But what do you think?
Richard: So big changes are happening in China now. There are, of course, the ongoing trade tensions between the US and China, and growing political tensions verging on Cold war. And now, at this time, China’s government President Xi Jinping, has decided to crack down on the tech companies and education companies and effectively, the Communist Party is exerting even greater control over the entire economy than ever before. And at this time, they have made the decision not to roll over Evergrand debt, not to give them more financing. So they are squeezing the property sector. And the property sector accounts for about a third of all China’s economic growth, or about a third of China’s economy is entirely driven by property. So the real danger for the rest of the world is not so much that the rest of the world is holding so much Chinese Evergrand debt that if it defaults, it’s going to cause a fiscal systemic financial sector crisis in the west. The real threat is that China’s economy is going to slow down very significantly because its main driver was property. And now there’s just so much excess capacity, property capacity. And the authorities are trying to crack down on it. Where’s the growth going to come from? If they stop building. That’s amazing. When you fly over China, you look down and you see thousands of skyscrapers, thousands of housing, 30, 40, 50 story residential buildings in blocks. It’s just extraordinary to see and that you can imagine how much cement and steel and concern and machinery and workers, all that is required to build if they stop building that now that’s going. And copper, for instance, you can imagine the sort of impact that would have on global demand for all of those products. So really, the US was the main driver of global growth for decades up until about 2008, as it ran very large trade deficits with the rest of the world. And that allowed the rest of the world to produce much more than it could have otherwise done. But after 2008, China really took over as the growth driver for the world by buying so many commodities and also through their belt and road project, where they have taken their excess cement and steel and sold it to African countries to allow their steel companies to continue manufacturing steel and keeping people employed. But now China is a global growth driver. Looks like that is going to slow substantially, which means that the global economy is likely to weaken economic growth globally.
Buck: Right. So you see it less as a now as Lehman Brothers and more as a type of situation where slowing down of the world’s fastest growing economy causes ripple effects throughout the rest of the world, basically because China’s demand for things goes way down.
Richard: Yes. I think in China, the authorities are not going to let things run completely out of control. They’re not going to let all the property companies start going bankrupt. They’re not going to let a lot of banks go bankrupt. Yeah. The bank can’t go bankrupt until the government says it’s bankrupt. And if China wants to keep its banks solvent, the central bank can just create money and give it to them, and they’ll be solvent. So unlikely this is going to be the near term financial sector implosion of China. That would be very surprising. But it does look like that the economy could start slowing significantly, much slower economic growth, which will be a drag on global economic growth and commodity prices and therefore leading to less inflationary pressures.
Buck: And then circularly back to the Fed, probably going back to its previous policy, right. I mean, it’s just a circular thing.
Richard: Right. So I think the big lesson that everyone needs to learn is that in the 21st century, in this age where we stopped backing money with gold 50 years ago, the thing that drives economic growth today is credit growth, right? Credit growth drove economic growth in the US going back to 119. 50 anytime credit grew by less than 2%. Adjusted for inflation, the US went into recession, and the recession didn’t end until there was another big surge of credit growth. So what we’ve just experienced in the US is a very big surge of total credit growth because the government borrowed $5 trillion a year and a half and pumped it into the economy. So that’s given the US the economic boom that is such as it is, 6% GDP growth last quarter, for instance. But now looking ahead, since the government is not going to keep borrowing $5 trillion every year, the credit growth is going to slow again, and we’re going to move back down to something closer to the credit growth instead of credit growth, which is what we had in 20. And as credit growth slows again, the economy is going to slow again. Credit growth drives economic growth. And we’re moving back into a period where credit growth is going to be weaker, it appears. And that will certainly be the case if the Fed does begin to increase interest rates if it gets very far along in hiking the federal funds rate, which they’re now talking about hiking beginning sometime at the end of next year. If interest rates go up and that’s going to make it even more difficult for the private sector to borrow and spend. So I think the economy could be considerably weaker in 2022 and 2023, then the general consensus currently holds.
Buck: Well, I guess we’ll have to see. And I bet the next time we have you on, hopefully it’ll start to declare itself a little bit more. I feel like the lack of really feeling like anything’s predictable is one of the hardest things for investors out there.
Richard: That’s right. And everything does change and so often in unexpected ways. Of course, one of the biggest threats is still quite unlikely. But a possibility is that the current Cold war between the US and China turned hot. The Chinese are now flying fighter jets over Taiwan practically every day. And if somebody makes a mistake, people could start dying. And if that happens, who knows what will happen? But it won’t be pleasant, right? If it gets out of control, because if there is any sort of significant shooting war with China, then all bets are off. All this that I’ve said about the deflationary pressures of globalization would immediately disappear. And all of the things that we’ve been buying from China, I certainly cost a whole lot more. Sure, practically overnight eating the very high rates of inflation. But again, I still view that is very unlikely, but still just discussing unexpected things that can go wrong. There are always plenty of them.
Buck: Richard, it’s always very interesting to talk to you. If people want to learn more, I would highly recommend to subscribe to Richard’s Macro Watch. Well, you tell us a little bit about that and where we can subscribe.
Richard: Thanks. So yes, people can find Macro Watch online, which is RichardDuncanEconomics.com. That’s RichardDuncanEconomics.com. The Macro Watch is a video newsletter which I started eight years ago this month, and every two weeks or so I upload a new PowerPoint presentation in which I discussed. There is audio and there’s the PowerPoint presentation. I discussed some important development in the global economy and how that’s likely to impact asset prices. For instance, today we’ve been talking about the liquidity tsunami and now the end of the liquidity tsunami. Those are the source of videos that I produce. And there are now roughly 75 hours of these Macro Watch videos in the archives. So anyone who subscribes will get a new video every couple of weeks and also have immediate access to all of these videos in the archives covering almost every important subject in Macroeconomics that you could ever want to know about. So I hope your listeners will take a look at Richard Duncan Economics. Com if they would like to subscribe. I’d like to offer them a 50% subscription discount. If they hit the subscribe button, they’ll be prompted to put in a discount coupon code. If they use the code formula, they can subscribe at a 50% discount. So I hope you’ll take a look.
Buck: Absolutely. I am a subscriber myself. Highly recommend it especially for a lot of you high paid professionals who never took Macroeconomics. And for those who did, obviously, it’s good to know what’s going on out there helps you be an educated investor and make some decisions based on more than your gut. So, Richard, I want to thank you again for being on Wealth Formula podcast, and hopefully we will catch up with you in a few months and see how things turn out.
Richard: Great, Buck. Thank you. I look forward to the next time.
Buck: Be right back.